Understanding break-even analysis

The break-even analysis is not our favorite analysis because:

It is frequently mistaken for the payback period, the time it takes to recover an investment. There are variations on break even that make some people think we have it wrong. The one we do use is the most common, the most universally accepted, but not the only one possible.

It depends on the concept of fixed costs, a hard idea to swallow. Technically, a break-even analysis defines fixed costs as those costs that would continue even if you went broke. Instead, you may want to use your regular running fixed costs, including payroll and normal expenses. This will give you a better insight on financial realities. We call that “burn rate” these post-Internet days.

It depends on averaging your per-unit variable cost and per-unit revenue over the whole business.

Over the past few years, the break-even analysis has fallen out of favor with financial analysts. It is okay when done right, can be useful, but not for all businesses and not for all situations. And, to add to the confusion, the term “break-even” is often used to refer to “payback” or “payback period.” And there are several ways to do the analysis. But what is shown here is the most common.

Three assumptions of the break-even analysis

1. Average per-unit sales price (per-unit revenue):

This is the price that you receive per unit of sales. Take into account sales discounts and special offers. Get this number from your sales forecast.

For non-unit based businesses, make the per-unit revenue one dollar and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate.

The analysis requires a single number, and if you build your sales forecast first, then you will have this number. You are not alone in this, the vast majority of businesses sell more than one item, and have to average for their break-even analysis.

2. Average per-unit cost:

This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs you, per dollar of revenue or unit of service delivered, to deliver that service.

If you are using a units-based sales forecast table (for manufacturing and mixed business types), you can project unit costs from the sales forecast table. If you are using the basic sales forecast table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50 percent margin would have a per-unit cost of .5, and a per-unit revenue of 1.

3. Monthly fixed costs:

Technically, a break-even analysis defines fixed costs as costs that would continue even if you went broke. Instead, we recommend that you use your regular running fixed costs, including payroll and normal expenses (total monthly operating expenses). This will give you a better insight on financial realities.

If averaging and estimating is difficult, use your profit and loss table to calculate a working fixed cost estimate—it will be a rough estimate, but it will provide a useful input for a conservative break-even analysis.

Illustration 2 shows a break-even chart. As sales increase, the profit line passes through the zero or break-even line at the break-even point.

Illustration 2: Break-even chart

The illustration shows that the company needs to sell approximately 1,222 units in order to cross the break-even line. This is a classic business chart that helps you consider your bottom-line financial realities. Can you sell enough to make your break-even volume?

The break-even analysis depends on assumptions made for average per-unit revenue, average per-unit cost, and fixed costs. These are rarely exact. We recommend that you do the break-even table twice; first, with educated guesses for assumptions, as part of the initial assessment, and later on, using your detailed sales forecast and profit and loss numbers. Both are valid uses.